Why Investing Only in "What You Know" Could Be a Mistake

Investing is a complicated business with potentially high stakes, so the temptation to focus on companies or products that you already know and like—say, the company that makes your mobile phone or a favorite soda brand—is understandable. But does it make sense?

"Investing in what you know" is one of those investing slogans that sound like wisdom, but can be an oversimplification. This particular saying has taken on an aura of respectability because of its link to fund-manager Peter Lynch and businessman Warren Buffett, two giants of the investing world who have suggested investing in what you know can be a useful strategy.

The idea is that being familiar with a business or product can be a good place to start when it comes to making investment decisions. Investors might be able to find potentially attractive opportunities by keeping an eye on people's shopping habits or applying their expertise from their jobs. For example, a barista with a hunch that a popular coffee chain is about to take the country by storm might use that as the spark of an investment idea.

Of course, even for the Lynches and Buffetts out there, familiarity might be just the first step in a journey that will include a lot of additional research and other financial considerations before any investments are made. In other words, "what you know" is better understood as "what you could thoroughly investigate."

But oversimplification isn't the only problem with this saying. Here are some other reasons why "investing in what you know" could result in you taking on risk that may not be appropriate for your situation.

You could end up overpaying. Buying the stock of a well-known company with a popular product can seem like a good idea—after all, success can mean growth and profits—but the chances are pretty good that you won't have been the first person to spot the opportunity. If other investors have already driven up the company's stock price, the company's future growth potential may already be priced in. Latecomers might find themselves paying a lot for a stock that doesn't have much more room to rise.

You could overlook good companies. The opportunity cost of not owning stock in a company during its early years, when it can grow the fastest, can be significant. Few people grasped the potential of personal computing in the 1980s, much less the Internet, but this industry has seen significant growth since then.

Your focus could be too narrow. Often people are deeply familiar with only a few sectors and companies, perhaps as a result of what they like to buy or where they work. But relying solely on your personal experience could leave your investments concentrated in a particular stock or sector. That could be risky if that stock or sector isn't growing or hits a rough patch.

That last reason raises an important point about best practices when it comes to building a portfolio of investments. While there's no way to completely avoid risk with investing, there is one important step you can take to help manage it: diversifying your investments. Diversification basically means investing in different kinds of assets to help make sure your portfolio doesn't depend too heavily on any single piece. If one investment is falling, another might be rising. Having both can help smooth the performance of your portfolio.

What does this have to do with "investing in what you know?" At the end of the day, it's unlikely that many individual investors will be familiar enough with all of the different assets that can be used to build a truly diversified portfolio. It can take a wide array of assets, ranging from familiar big American companies to small foreign ones, as well as a variety of fixed-income investments, commodities, cash and other assets.

No one's saying this is easy. Researching and selecting securities takes time and expertise. And investing in something you aren't totally familiar with can feel more like a leap of faith than a rational investment in your future.

Investing in exchange-traded funds (ETFs)—baskets of securities that track an index and trade like stocks on exchange—can be a step in the right direction. When you buy one, you can gain access to a collection of stocks, bonds or other investments that may already be fairly diversified.

Unfortunately, picking between ETFs could be just as complicated as picking individual stocks or bonds. Some ETFs perform better than others, and their objectives, risks and costs can vary widely. And then there's the problem of how to keep a portfolio of different ETFs balanced to match your goals, risk tolerance and time-horizon. As the different ETFs rise or fall, they might account for a changing share of your overall portfolio. Such fluctuations are a normal part of investing, but if your portfolio moves too far from your desired allocation, you could end up with more risk or less growth potential than you planned for. Making sure your portfolio remains aligned with your target allocation and risk profile can add another layer of complexity.

Sound daunting? Fortunately, there are options out there to help make the process easier.

Did You Know?

Schwab Intelligent Portfolios™ can build a diversified portfolio of ETFs that includes up to 20 asset classes across stocks, fixed income, real estate and commodities, as well as an FDIC-insured cash component.

Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Unlike mutual funds, shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Investing involves risk including loss of principal. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Cash balances held in the Sweep Program at Schwab Bank are eligible for FDIC insurance up to allowable limits.